Overview
Stocks which provide investors with a steady stream of income via dividends are typically referred to as “dividend stocks”. These are typically more established companies which seek to return capital to investors versus reinvesting all earnings back into growth of the business. For example, let’s say company A has $500 million in net income in a given quarter. It may choose to keep $250 million to invest in new projects to expand and improve its business, and pay the remaining $250 million out as a dividend to investors. Therefore, its dividend payout ratio is equal to $250 million / $500 million = 0.5.
The Upside
These stocks provide investors with stable income and a return on investment which is in addition to any price appreciation of the stock. That is, if the stock has an annual dividend yield of 2%, and the stock price goes up 10% in a given year, investors get a total return of 12%.
The Downside
Two words: double taxation. Remember that stockholders are essentially partial owners of a company. The company is taxed on its earnings at the corporate level by the government. In addition, stockholders must also pay taxes on the dividends they receive from the company. As a result, stockholders are actually taxed twice on their share of company earnings. This is why some companies do not offer a dividend, but instead prefer to use a stock buyback to provide investors with a return on investment.
Related Links: Value Stocks, Growth Stocks